Six Tests Your Financial Planner Should Pass


A new report co-authored by Sendhil Mullainathan, a leading behavioral economist and Harvard professor, raises troubling issues about the competence of financial planners.

Mullainathan got 300 actors to pose as prospective clients seeking investment advice from financial planners. They had four distinct objectives. One group pretended to be invested in index funds, another in cash, another said they were seeking the next hot market sector and the final group said they held a third of their portfolio in company stock.

The results of their interviews were remarkably consistent. The financial planners verified these clients' biases and told them what they wanted to hear. For investors who rely on the "independent" advice of financial planners, this is disturbing news, because a good financial planner should bring objectivity to the process. Here's my six-point litmus test for financial planners.

  1. They work on a fee-only basis. Financial planners cannot provide unbiased advice if they have a financial incentive to steer you toward buying some financial products and discourage you from purchasing others. You should not retain a financial planner who won't agree to either an hourly or fixed project fee. Typically, the fee is determined as a percentage of assets under management. Investors should also be wary of paying commissions, including trading commissions. This arrangement encourages trading, which increases costs. High costs are the mortal enemy of returns.

  2. They agree in writing to act in a fiduciary capacity (which means they must always act in your best interest and have no conflicts of interest).Why would you entrust your assets to someone who may have a conflict of interest with you? Any reputable financial planner should have no problem with this request. All registered investment advisors are legally required to act as fiduciaries to their clients. The rub comes with stock brokers. Currently, they are only obligated to recommend investments that are "suitable" for their clients, which means there still may be a conflict of interest. Congress is currently debating whether to require all financial professionals, including stock brokers, to adhere to the same fiduciary standards required of registered investment advisors. However, the measure is unlikely to pass due to lobbying efforts of industry trade associations like the Securities Industry and Financial Markets Association.

  3. If you are trusting someone to set your financial goals, they should have stellar qualifications (this applies to financial planners only). When selecting a financial planner be sure they hold either a PhD in finance or economics, an MBA, a CPA (certified public accountant) or some other certification from an accredited institution, like a CFA (chartered financial analyst) designation.

  4. Their investment advice focuses on your asset allocation (the division of your portfolio between stocks, bonds and other assets). Many academic studies demonstrate the critical importance of asset allocation when it comes to portfolio returns. It is far more important than stock picking, market timing or fund selection. Nevertheless, financial professionals often focus on these relatively minor factors and ignore asset allocation. If your planner or advisor doesn't appreciate the importance of asset allocation, find someone who does.

  5. To the extent they make investment recommendations, advice is limited to ensuring that you have a globally diversified portfolio of low-cost stock and bond index funds in an asset allocation appropriate for your risk tolerance and investment objectives. Most advisors and virtually all brokers will tell you they add "alpha," which is a fancy term for beating the markets. Their hope is that you are not familiar with the overwhelming data indicating the majority of mutual funds that attempt to beat their designated benchmark (like the S&P 500 index) fail to do so. Those that do are frequently incapable of repeating their stellar performance. Investors should avoid advisors and stock brokers who put together portfolios of individual stocks, pick market sectors they believe are going to outperform or recommend "actively managed" mutual funds, where the fund manager attempts to beat a benchmark index.

  6. If you require advice on insurance or insurance-related products, they refer you to a fee-only insurance consultant who does not sell, or benefit from the sale, of the insurance you purchase. The insurance consultant will also agree in writing to act in a fiduciary capacity. Few people who shop for insurance understand that their insurance agent is not required to be a "fiduciary." The interest of the agent (commissions) is often in direct conflict with your interest. To make matters worse, insurance is a very complicated product. The range and complexity of insurance products makes it an area where most buyers need independent, objective advice. If you are considering a significant purchase of insurance, retaining a fee-only insurance consultant can be a wise investment. They are paid on an hourly basis and have no financial interest in any product that you may decide to purchase. The cost of their advice can be minor compared to the savings and peace of mind they provide.

A financial planner who tells you what you want to hear can make you feel good -- but can cause significant damage to your financial well-being. Just say "no" to financial planners who always say "yes."

This story was updated and supplemented on March 16, 2009.
Also, the third point in the story was changed after the initial publication of the story.